What Selling a Rental Costs in California

Selling a rental in Sacramento or the foothills can involve four separate tax pieces. Most owners only plan for one. Here is each piece in plain English, followed by an illustration with round numbers.

Piece 1: Federal Long-Term Capital Gains

If you held the property more than one year, your gain is long-term. Federal long-term capital gains are taxed at 0%, 15%, or 20%, depending on your taxable income. The income cutoffs for each rate change by year and filing status, so ask your CPA which rate applies to you.

Piece 2: Federal Tax on Depreciation (Unrecaptured Section 1250 Gain)

Depreciation lowers your basis, which raises your gain. The part of the gain tied to depreciation on real property is called unrecaptured section 1250 gain, and it is taxed at a maximum federal rate of 25%.

This applies to depreciation you deducted or could have deducted. Skipping it on your returns does not avoid it.

Piece 3: Net Investment Income Tax (3.8%)

The Net Investment Income Tax (NIIT) is a separate federal tax of 3.8%. Gains from selling real estate generally count as net investment income, unless the property is held in a trade or business that is not subject to the NIIT.

It applies to the lesser of your net investment income or the amount your modified adjusted gross income exceeds these thresholds:

• Married filing jointly: $250,000
• Married filing separately: $125,000
• Single or head of household: $200,000

A large sale can push an owner over the threshold in the year of sale, even if their income is usually below it.

Piece 4: California Income Tax

California does not have a lower rate for capital gains. All capital gains are taxed as ordinary income. That means your gain is added to your other income and taxed at your regular California rate, which can be high in a big sale year.

California Withholding at Closing (Form 593)

When you sell California real estate, the escrow company generally withholds part of the proceeds and sends it to the Franchise Tax Board. This is reported on FTB Form 593.

• Standard rate: 3 1/3% of the sales price.
• Alternative: you may elect withholding based on your estimated gain times a set rate, which can lower the amount when your gain is small relative to price.
• Common exemptions: sales of $100,000 or less, a qualifying principal residence, and the initial transfer in a deferred like-kind exchange.

Withholding works as a prepayment toward your California tax. You claim the amount withheld on your California tax return.

An Illustration (Not a Calculation of Your Taxes)

The numbers below are made up and rounded to show how the pieces fit. They are not a calculation of anyone's taxes. They ignore selling costs, improvements, land versus building allocation, and many other real factors.

Illustration: - Purchase price: $400,000 - Depreciation taken over the years: $100,000 - Adjusted basis: $300,000 - Sale price: $700,000 - Total gain: $400,000

How that $400,000 gain is treated, in general terms:

• Federal, depreciation portion: about $100,000 of the gain is tied to depreciation. Federally, that part is taxed at a maximum 25% rate.
• Federal, remaining long-term gain: the other $300,000 is taxed at the federal long-term capital gains rate that fits the owner's income: 0%, 15%, or 20%.
• NIIT: if the owner's modified adjusted gross income is over the threshold for their filing status, some or all of the gain may also face the 3.8% NIIT.
• California: the full $400,000 gain is taxed as ordinary income at the owner's California rate.
• Withholding at closing: at the standard rate, 3 1/3% of the $700,000 sales price is about $23,300 withheld by escrow and credited on the California return.

The takeaway: a single sale can touch four taxes plus withholding. Your CPA can run your real numbers.

How a 1031 Exchange Changes This

In a qualifying 1031 exchange, gain is not recognized when you trade into like-kind real property, and the initial transfer is exempt from California withholding at that time. The gain is deferred until a later taxable sale. See how a 1031 exchange works.